Kangaroo Markets

“I’ve worked with dogs before and they’ll sit and they’ll roll over. With kangaroos, you say sit and they start boxing with you, they’re nuts.”

-Jerry O’Connell

Keith is out on some family business today, but I think he would, after the last 24+ hours of global market trading, agree with the titled of this note: Kangaroo Markets. As creative as I can be at times, I have to give credit for the origin of the title to its rightful owners, the Aussies.

In another capital markets sign of the topping of the global economic cycle, it seems Kangaroo Bond sales surged to a record A$37.3 billion last year and are on track to nearly match that total this year. As a prominent Australian fixed income manager recently said to the financial press, “I expect more financial kangaroo sales.” Indeed, and we expect more kangaroo markets, which is to say markets that are “nuts”. Now, of course, markets can’t really be nuts, but Centrally Planned Price Volatility can certainly make those of us who trade them nuts.

Yesterday’s market action likely didn’t reward many. The dollar index rallied hard, so commodities were taken out to the woodshed and U.S. equities were down -1% or so with the small cap Russell 2000 leading the way to the downside at -1.8%. The pundits are calling this the “risk off” trade. I’m not sure risk is really ever off, but it is a convenient way of explaining that many investors got caught leaning way too hard into consensus. Or, perhaps, all the Hedgies at the SALT conference just aren’t trading this week…

The other important event yesterday related to the investment management industry was that Raj Rajaratnam, head of Galleon Management, was found guilty on all 14 counts of fraud and conspiracy. Personally, I don’t have a lot of knowledge about the case, but I can tell you this, Raj’s lawyer certainly thought he was in a Kangaroo Court as he announced immediately after the verdict that they intended to appeal to the Second Circuit.

To the extent that this was actually a catalyst for the market yesterday, there is another catalyst in the pipeline on this front, which is the trial of Zvi Goffer, more commonly known in technology insider trading circles as Octopussy, who according to the accusations and this chart from the WSJ (http://online.wsj.com/article/SB10001424052748703386704576186592268116056.html) was purportedly in the middle of a web of inside information. Personally, I just think he had a terrible nickname.

The bigger question, of course, is what does this all mean for the investment management industry? Luckily, despite the headlines, most actors in the investment management industry are ethical and have legal processes, so the prevalence of cheating is likely much less than the headlines would currently suggest.

In an unusual move, before we even had paying clients at Hedgeye we brought on board our compliance officer, Rabbi Moshe Silver, a Wall Street veteran of over 25 years. Prior to joining Hedgeye, Moshe worked with Keith at the Carlyle-Blue Wave hedge fund, where he was director of compliance. When Moshe came on board he recommended we introduce ourselves and our unique business model to our regulators – another unusual move, but in this day and age of increased scrutiny, we thought it was appropriate.

Moshe’s contributions have expanded to sharing his unique – and occasionally hilarious – insights into the world of regulation, un-regulation, and the shadowy places where Wall Street and the Real World meet. His thoughts appear in a weekly column that is a must-read for many of our clients. Needless to say, Moshe hasn’t been effective at limiting our use of hockey references, but we’re glad he’s got our back as he oversees our research and communications to ensure that compliance always comes first.

If there is any potential market impact of more insider trading trials and investigations, it is perhaps to accelerate Centrally Planned Price Volatility. We've highlighted this last point in the chart below. Over the course of the past decade when interests rates have been taken to abnormally low levels, such as in the 2002 – 2003 period and in the 2008 – current period, price volatility increases, as emphasized by the VIX stepping up to a new level.

In theory, this makes sense. Aside from attempting to artificial co-opt the natural business cycle, the other impact of our Central Planners taking interest rates to abnormal levels for extended periods is to force investors to speculatively chase return. Practically, what does that mean? As an example, it means bidding oil up into the $100+ level when global growth is slowing and global oil inventory is building. This works, of course, until it doesn’t and then the trade gets unwound, as we are seeing again this morning with the commodity complex down across the board and silver leading the way, down a cool -8.5%. (But wait, silver’s an industrial metal! Or is it?)

Underscoring the heightened commodity and equity market volatility we are seeing is currency volatility. This is a function of both the Central Planners at the Federal Reserve, but also the Fiat Fools in Washington, who are currently playing politics with the fiscal future of the United States on the debt ceiling debate. For a comprehensive review of our thoughts on the debt ceiling debate, please see the note written by my colleague Darius Dale yesterday, titled “Fear Mongering Meets Brinksmanship: A Comprehensive Guide to Navigating the Debt Ceiling Debate.”

Be it the moniker Octupussy, or the Fiat Fools in Washington, some days all of this just seems a little childish, so with that we’ll end with a nursery rhyme:

“Jump, jump, jump goes the big Kangaroo,

I thought there was one, but I see there are two.”

Indeed.

Keep your head up and stick on the ice,

Daryl G. Jones

Managing Director

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05/12/11 08:00 AM EDT

Fiat Laws

This note was originally published
at 8am on May 09, 2011.
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“Man is free if he needs to obey no person but solely the laws.”

-Immanuel Kant

Kant was an 18th century German philosopher who over-weighted the value of real-life experience versus academic theory. Hayek used Kant’s aforementioned quote in “The Road To Serfdom” to support his point that unchecked government planning and the Rule of Law run counter to each other’s objectives.

“By giving the government unlimited powers, the most arbitrary rule can be made legal; and in this way a democracy may set up the most complete despotism imaginable.” (F.A. Hayek, “The Road To Serfdom”, 1944, page 119).

Since professional politicians gave Hank Paulson the TARP “bazooka” and started begging The Bernank for both “shock & awe” rate cuts to zero (2008), then The Quantitative Guessing (2009-2010), we’ve been waking up every morning trying to manage risk around Fiat Laws.

This morning’s speculation as to what the European Union is going to do with Greece’s $110,000,000,000 lifeline of bailout Euros is no different than the perpetual risk management exercise of Gaming Policy that we engage with here in the US. It’s a sad state of the “free” market union.

The good news is that we can measure the Global Macro risks embedded in the next Big Government Intervention mathematically. If the intermediate-term TREND of US Dollar Debauchery is going to change, the currency market is going to signal that to us in real-time.

Last week’s short squeeze in the US Dollar did exactly what we thought it would do if and when it stopped crashing – it started making everything else start to crash. The Bernank calls this “The Price Stability.”

With the US Dollar closing up +2.6% week-over-week (only it’s 5th up week in the last 19 weeks), here’s what The Correlation Risk looked like:

Euro = DOWN -3.4%

CRB Commodities Index = DOWN -8.9%

WTI Crude Oil = DOWN -14.7%

Gold = DOWN -4.2%

Copper = DOWN -4.8%

Volatility (VIX) = UP +24.7%

No, that’s not a typo on the marked-to-market pricing of The Price Volatility associated with The Bernank pandering to the political winds and keeping “hope” for a 3rd round of rule making (QE3) alive.

Now, for myself, The Price Volatility is cool because I’m trying to prove that Big Government Intervention in our markets does nothing but A) shorten economic cycles and B) amplify market volatility.

For our profession and the economy that we live in, it’s not so cool. Last week’s US jobless claims (474,000 – breaking out to the upside) reflect this. So does the weekly Bloomberg consumer confidence survey coming in at minus -46.1. Volatility crushes confidence.

While there is a lot of partisan fanfare about a “bull market in stocks”, I don’t think I have ever seen so much storytelling go alongside a +6.6% YTD return for the SP500 since I started in this business 13 years ago.

Globally, as of Friday’s closing prices, the big “bull market” in equities isn’t especially bullish looking either. Take a look at the Top 3 Global Equity market performers for 2011 YTD:

Venezuela = +17.6%

Hungary = +11.2%

Romania = +10.0%

Go Chavez and the Keynesian Kingdom?

Notwithstanding The Price Volatility that it’s taken us to get to another lower-long-term high in US Equities (down -14.4% versus it’s October 2007 peak), isn’t it interesting that there are only 3 stock markets in the world with double digit returns for the YTD?

Markets aren’t “free” – at least not like they used to be. And being reminded of that last week is why I took up the Cash position in the Hedgeye Asset Allocation Model on the Bin Laden news. Here are my current asset allocations and positions:

Cash = 43% (versus 34% last Monday)

International Currencies = 24% (Chinese Yuan and British Pounds – CYB and FXB)

Commodities = 12% (Gold and Oil – GLD and OIL)

Fixed Income = 9% ( US Treasury Flattener – FLAT)

International Equities = 6% (China – CAF)

US Equities = 6% (Technology – XLK)

As a reminder, the way I think about asset allocation is the way I think about my own net worth. I’m not saying that’s a perfect methodology for everyone else – I’m just saying it’s the only one I can hold myself accountable to. So after a +98.2% two-year rally in US stocks (where we got bullish in 2009), it shouldn’t be a surprise to see me wait and watch for my spots to get invested again.

We made a call in April of 2010 called “May Showers” that saw The Price Volatility index (VIX) shoot up to 45 by June. Looking ahead at the US political calendar of deficit and debt ceiling debates this June, I’m not especially hurried to be levering myself up alongside my least favorite Fiat Fools either. I’d rather obey my own risk management laws.

My immediate-term support and resistance line for Gold are $1485 and $1521, respectively. Immediate-term support and resistance for oil are $98.63 and $109.11, and my immediate-term support and resistance lines for the SP500 are now 1333 and 1351, respectively.

THE HEDGEYE DAILY OUTLOOK

THE HEDGEYE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP - May 12, 2011

In our Q2 Global Macro Theme slide deck, we call this stage of asset prices (relative to USD) “Deflating The Inflation” – send an email to if you need those slides and scenario analysis (we also have the conference call replay on the Hedgeye Portal).

Obviously with last week’s hyper correlation risk (USD +2.6% week = Oil down -14.7%, CRB -8.9% on the week, etc), yesterday’s unwind was proactively predictable. USD UP = CRB index down -2.9% on the day – and oil hammered (we made a call to sell Oil on Tuesday).

The Hedgeye models are registering immediate-term TRADE (3 weeks or less) downside in WTI Crude Oil this morning of $93.33/barrel. That’s eye opening – and the other side of the biggest net long position in hedge fund history should be. The only “commodity” we are long here is gold. The Immediate-term TRADE ranges to watch on the way up to USD immediate-term TRADE overbought line = 75.79:

The reason why the Hedgeye models have USD and Euro “neutral” in the immediate-term is that the big moves in both are now in the rear view mirror! USD is bullish TRADE, bearish TREND whereas Euro is bearish TRADE (resist = 1.44), bullish TREND (support = 1.40). As we look at today’s set up for the S&P 500, the range is 18 points or -0.83% downside to 1331 and 0.52% upside to 1349.

Risk Managed Long Term Investing for Pros

GENTING SINGAPORE: 1Q11 CONF CALL NOTES

Huge quarter but upside from consensus was all due to high hold.

"The first quarter 2011 revenue are good as a result of the execution of our overseas marketing plans. The enhanced product offerings and service excellence that our customers demand, will allow us to build significant brand equity over time as the foremost destination resort in Asia."

HIGHLIGHTS FROM THE RELEASE

Genting Singapore IR 1Q11 detail (S$MM's):

Casino revenue: 804.4MM

Non-gaming non-gaming: 109.154MM

Adjusted EBITDA: 537.9MM (59% EBITDA margin)

Group revenue was S$922.6MM and Adjusted EBITDA was S$529.4MM

"Singapore IR experienced good win percentage and gaming volume in the first quarter of 2011 with steady growth in Universal Studio Singapore (“USS”) and the hotels."

USS daily average visitation: 7,400 and average daily spend per visitor was: S$88 per visitor

Hotel occupancy: 79% and ADR: S$280

D&A: S$76.6MM

"Higher finance costs of S$39.7 million was mainly due to charges related to the refinanced syndicated loan facility"

"Higher taxation of S$77.4 million in the first quarter of 2011 mainly from the higher deferred tax expenses due to temporary difference in property, plant & equipment."

Capex in the period was S$0.46BN

"Our Casino VIP rolling market segment continues to be a major contributor to the total gaming revenue with growth compared to the previous quarter at 19%. The Casino VIP rolling revenue is now 62% of the total gross gaming revenue."

"We are delighted that we have been able to attract record volumes of overseas visitors to our resort, and Universal Studios Singapore continues to be a major draw for the young and not so young from around the region."

"Hotel occupancy has been good and our bundled products have been extremely popular. Quarter 2 bookings continue to be encouraging and we look forward to a strong summer holiday season."

"We are encountering some unforeseen difficulties which may delay the completion of the second phase. However, we are addressing this issue and have allocated resources to catch up with the schedule."

CONF CALL NOTES

Next week, Journey from Madagascar will open and USS will celebrate its grand opening

VIP net revenue market share has grown from 65% to 68%

They believe that the Mass market has entered a steady state, and therefore will not show big growth with aggressive marketing and comps to the local population which they won't do

3.8% hold rate this quarter helped achieve their high margin this quarter

Gaming revenue was 88% of total rev

No update on junket approvals

MICE team did over 670 events, making the IR one of the 3 most active MICE players.

Maritime Museum is set to open in the quarter, which should be a big attraction

Q&A

Rolling was 60% of their revenue, non-rolling was 40% - so they still have the majority market share in both segments

There will definitely be organic growth in Mass, but it has usually tracked GDP plus around the region

Long term stabilized margin target is still between 45-50%

Was there a sequential decline in the RC volumes?

RC volume declined sequentially and they expected that given that when people lose faster they roll less

Post Golden Week, they are still quite happy with business

Delays on PH2?

There are minimal capex implications

The delay is a few months due to design enhancements

The delay is specific to just a few components - but they wouldn't elaborate

Any thoughts on a clamp down post election?

They will not pursue any marketing campaigns targeted at the local market

Level of write-offs?

Ratio of the provision of bad debt vs. receivables has come down

Seasonality?

Still hard to say until another year or so

Will be opening parts of the West zone in the 2H11 which will positively impact the visitation to the resort

Taxes is their largest expense, followed by primarily fixed labor expenses (20% is variable / 80% fixed). They don't see any significant expense increase.

ETG's increased by about 150 machines. They are getting a little better than organic growth on the ETG side. The max is 2,500 and they are at 2,000 ETGs

The restriction on their gaming floor is the restriction on SQFT on the main gaming floor - they are always tweaking the mix to maximize revenues

589 tables at 3/31/2011 (30% are VIP); 1,437 slots, 363 ETGs

Interest expense: The facility is already fully drawn down. Going forward the interest expense will be a little lower because this quarter includes a refinancing fee

Market share for RC volume was 59% vs 4Q share was 67%

How much of their gaming SQFT have they used so far?

90%

Still in the planning stage for the rest

There was a reduction in construction payables this quarter

What's the residual capex for the West Zone?

1Q capex wasn't for west zone - so there is still S$700-800MM to be spent of which S$100MM has been spent

VIP net revenue was 50% of net total gaming revenue and 62% at the gross level of total gaming revenue

The commission rate was slightly lower than last quarter - they are not buying the business or increasing commissions

VIP demographics - the market segmentation is still similar and don't see material shifting

Allocated minimal space to poker on their floor. They will continue to tweak their mix on on the floor to maximize win

First quarter they have collected a lot more of their receivables than last Q - less than 40% of receivables are past 30 days due

Mass market drop was pretty flat but they held pretty well

Would EBITDA have been S$400-410MM for the Q if hold was 2.8%?

No Comment

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05/12/11 07:11 AM EDT

TALES OF THE TAPE: SBUX, WEN, TAST, CMG, SONC, TXRH, RRGB

Notable news items and price action from the past twenty-fours along with our fundamental view on select names.

In the QSR space the notable call-outs were WEN, TAST and SBUX all down more than 1% on accelerating volume

In the FSR space the notable outperformers were RRGB, CPKI and TXRH; all up on accelerating volume

Sonic plans to simplify its crowded food-and-drink lineup when it introduces new menu boards on May 26. But gaining breathing room comes at the cost of removing 18 slower-selling items. In the short run SSS will suffer.

Chipotle Mexican Grill Inc's (CMG.N) legal costs are starting to rise as the result of a federal probe into its hiring practices - CFO

Conclusion: We expect the current debt ceiling debate to heat up substantially in the coming weeks, resulting in a measured pickup in volatility across global financial markets, primarily as a result of increased volatility in the US Dollar being driven by the whims of D.C. politicking. Further, we expect the debt limit to be increased prior to any sort of default on any of the federal government’s obligations. And within that legislation, we would expect to see the groundwork laid for potentially meaningful fiscal reform ahead of the FY12 budget debate – an event that is likely to prove dollar bullish when it’s all said and done.

Position: Short the US Dollar (UUP);Long Gold (GLD).

With the debt ceiling debacle looming over the horizon, we thought we’d use the opportunity to equip you with an in-depth guide for navigating the next 3-4 months of what is likely to be heightened volatility for global currency, bond, and equity markets. Even as QE2 expires in June, macro markets are likely to continue to gyrate on the whims and words of a few “inspired” politicians within our nation’s capitol.

In short, while we accept the consensus belief that the debt ceiling will eventually be extended prior to any sort of default on the US government’s obligations, we do believe the events and rhetoric leading up to the passage of any deal will be anything but “smooth sailing”. As such, we are in the process of taking down our gross and net exposure within the Hedgeye Asset Allocation Model and Virtual Portfolio due to our expectation of heighted volatility in the months ahead. Below we explain the drivers of said volatility via an in-depth analysis of the current political situation and previous debt ceiling impasses.

Current Situation

Hitting the Ceiling: Congress created the statutory federal debt limit in the Second Liberty Bond Act of 1917 as a result of negotiations which resulted in securing financing for WWI and creating an additional check on the fiscal power of the executive branch/ruling party. While federal debt is appropriately divided between debt held by the public and intra-governmental debt, nearly all of it is subject to the limit. The powers that be at the time of creation appropriately intended the debt ceiling to be a reoccurring opportunity to reassess the direction of the US’s fiscal policy. It is, however, not without limitations, as the current consequences of not increasing the debt ceiling almost always outweigh the current consequences of extending it, making it quite toothless from a policy making point of view.

Creating Headroom: As indicated in Treasury Secretary Geithner’s most recent letter to Congress on May 2nd, we are scheduled to hit the current $14.294T debt limit on this upcoming Monday, May 16th. As such, Geithner & Co. must take “extraordinary measures” to ensure the US government has enough cash on hand to navigate the timing of cash flows in order to fulfill its existing obligations.

The first trick in his bag of is to declare a “debt issuance suspension period”. This allows him to suspend (until further notice) the issuance of State and Local Government Securities, prematurely redeem existing Treasury securities held by the Civil Service Retirement and Disability Fund, suspend the issuance to that fund as investments, and suspend the daily reinvestment of Treasury securities held by the Government Securities Investment Fund of the Federal Employees Retirement System Thrift Savings Plan. In addition, he may be forced to suspend the daily reinvestment of Treasury securities held as investments by the Exchange Stabilization Fund. For the sake of brevity, we’re not going to explore in this report the exact technical mechanisms by which these measures contribute to freeing up headroom under the debt ceiling, as the net result of each step is overwhelmingly benign as it relates to the economy and financial markets. For all those interested in digging into these processes a bit more, we are happy to follow up with you.

All told, in conjunction with “higher than expected tax receipts”, the aforementioned measures are expected to extend the Treasury’s borrowing authority until “roughly” August 2nd under current projections for financing needs ($738B through the September 30th end of FY11 as of April 27th). The Treasury has asked for a $2 trillion hike in the debt limit to accommodate financing through FY12 under current budget projections.

After the ceiling is hit on or around that date, the US government will begin to default on its obligations absent an increase in the debt ceiling or some form of temporary legislation exempting new issuance from being counted towards the statuary debt limit. What is being made clear by Geithner’s letters to Congress is that he considers any failure to pay any of the US government’s obligations (not just interest payments and principal redemptions on Treasury securities) as a detriment to the full faith and credit backing America’s hand shake. While we don’t often agree with the man, we do find common ground on this principle and we believe the vast majority of Americans would agree. Below is a list of federal government liabilities that would be directly impacted should the debt ceiling not get raised in time:

US military salaries and retirement benefits;

Social Security and Medicare benefits;

Veteran’s benefits;

Federal civil service salaries and retirement benefits;

Individual and corporate tax refunds;

Unemployment benefits to States;

Defense vendor payments;

Student loan payments;

Medicaid payments to States; and

General operational expenses for federal government facilities.

Net-net, the sheer breadth of this list alone gives us conviction that Congress will ultimately enact a permanent increase in the debt ceiling or at least kick the can down the road by temporarily upping the limit to accommodate borrowing needs through the either the remainder of FY11 or CY11. Of course, as with all of life’s many destinations, it’s the journey there that matters most. Given that, we offer the next section as a guide for the road ahead.

Political Stakes: Since 1960, Congress has passed legislation which increased (permanently or temporarily) or revised the definition of the debt ceiling 78 times – 49 times under Republican presidents and 29 times under Democratic presidents. So while it may seem like reaching the debt ceiling is a big deal at face value, in reality, increasing the debt limit is quite a common occurrence.

Judging by the political posturing and partisan rhetoric being thrown around Capitol Hill currently, however, we expect this round of Piling Debt Upon Debt to be anything but commonplace – especially with characters like Boehner and Reid leading the charge. The next few months will be full of enough headline-worthy news quotes, political posturing, brinksmanship, and enough fear mongering to rattle global financial markets. As we outlined at the beginning of the year, the 112th Congress is among the greatest risks to global financial stability. This summer we expect them to prove us right in spades.

As such, we’ve compiled recent quotes from politicians on either side of the aisle in an effort to outline the strategies and goals of each party in the upcoming negotiations. While paraphrasing would indeed save time and space, we find their messages better delivered by actually “YouTubing” these bureaucrats at face value. Also, if we’ve learned anything from the near government shut down we’ve recently experienced several weeks back (over just $38.5B in “reported” budget cuts), it’s that neither side is afraid to send us to the edge of chaos in order to advance their political agenda.

Democrats

5/9: Charles Schumer, Chairman of the Senate Rules Committee, NY: “Mr. Boehner needs to have an adult moment here and now… This next speech by the Speaker will be a litmus test on whether House Republicans plan to finally approach the debt ceiling as adults. So far many of them have not been responsible about this issue at all.”

5/9: Roger Altman, Chairman of Evercore Partners, former Treasury Secretary under Clinton, and consultant of Sen. Schumer: “Markets could crash if it begins to look like Congress will allow a default.”

5/10: Kent Conrad, Senate Budget Committee Chairman, ND: Unveiled a budget proposal which called for a 50-50 split between spending cuts and tax increases. The plan was immediately rejected by Republicans.

5/10: Jay Carey, White House Press Secretary: “It is folly to hold hostage the vote to raise the debt ceiling to prevent the United States of America from defaulting on its obligations to any other piece of legislation… Maximalist positions do not produce compromise.”

5/10: Chris Van Hollen, MD: “We have identified some areas of common ground [in today’s bipartisan meeting]. The major areas of disagreement have not yet been engaged.”

Republicans

1/7: Mike Huckabee, former Governor of AR: “One of the things that gives a little bit of juice for the Republicans is that Senator Barack Obama in 2006 stood on the Senate floor with an impassioned speech, saying that we should not raise the debt limit, that it was the lack of leadership, and that George Bush was just completely derelict in duty by asking Congress to raise the debt limit… Mr. President, we certainly don’t think you’ve made this radical change in just a few years, so we’re going to take you up on it.”

5/5: John Boehner, Speaker of the House, OH: “Instead of talking about billions [of budget cuts], I think it’s time to start talking about trillions. They should be actual cuts and program reforms, not broad deficit or debt targets that punt the tough questions into the future... Nothing is off the table except raising taxes.”

5/5: Mitch McConnell, KY: “We face a crisis that makes the panic of 2008 look like a slow day on Wall Street.” Still, McConnell suggested to the Senate floor that he would only vote for an increase in the debt limit in exchange for “deep and permanent” cuts in federal spending.

5/5: Steve King, IA: “I’d put the cutting off of all funds to ObamaCare on that debt ceiling bill and say, there’s going be no raising of the debt ceiling here by the House of Representatives unless we shut off all funding that is going to implement or enforce ObamaCare.”

5/5: Paul Ryan, WI: “[Spending] caps in and of themselves, alone I don’t think our conference would accept that. The GOP wants a down payment of spending cuts… Knowing that we are very far apart between the president, the Senate and where we are, we are not under any illusion that we’re going to get some grand- slam agreement… getting a single or double instead of a home run is the goal of the talks… Tax increases are off the table and triggers for automatic tax increases are a cop-out for those who cannot cut spending.”

5/9: John Boehner, Speaker of the House, OH: “To increase the debt limit without simultaneously addressing the drivers of our debt – in defiance with the will of our people – would be monumentally arrogant and massively irresponsible. It would send a signal to investors and entrepreneurs everywhere that America still is not serious about dealing with our spending addiction... It’s true that allowing America to default would be irresponsible, but it would be more irresponsible to raise the debt ceiling without simultaneously taking dramatic steps to reduce spending and reform the budget in the process.”

5/9: Michael Steel, Spokesman for Boehner: “The American people flatly reject Senator Schumer’s call for a blank check for the Democrats who run Washington to keep their spending spree going. There’s no way an increase in the debt limit will pass without real spending cuts and reforms.”

5/11: Eric Cantor, House Majority Leader, VA: “The substance of [Tuesday’s] discussions was trying to focus in on areas where we can cut spending and cut it big.” He affirmed house support for Boehner’s recent demands for trillions of dollars in budget cuts, saying “Anything less is not serious”.

Tea Party

4/10: Sarah Palin, former VP nominee and Governor of AK: “There needs to be an understanding in the GOP leadership that we cannot provide another tool for the liberals to just incur more debt, and that’s what raising the debt ceiling is going to allow again.”

5/9: Michele Bachmann, MN: Recently stated that any vote to raise the debt ceiling must be attached to a bill fully de-funding ObamaCare. She also criticized Boehner for “squandering” an opportunity to cut spending in the latest continuing resolution.

5/9: William Temple, Head of this fall’s Tea Party National Convention: “We’re telling Boehner and all of the House Republicans they came into office with Tea Party help. We now expect them to keep their promises and hold the ceiling on the national debt.” He added that the party would support a small increase if it were to be accompanied by a major policy win such as the repeal of ObamaCare.

All in all, the gaping divide between the two ideologies on what it would take to collectively lift the debt ceiling by early August is omnipresent in their recent commentary. While it’s clear that some fiscal reform will be included in any legislation towards increasing the debt ceiling (US dollar bullish), it’s almost equally as clear that: a) it will fall short of current Republican demands (US dollar bearish) because the Democrats are, on the margin, willing to stand their ground and engage in this game of political brinksmanship (evidenced by GOP leaders backing away from their recent support of Paul Ryan’s Medicare reform plan); and b) as political brinksmanship inches us closer to the deadline, we are likely to see a measured increase in fear-mongering quotes that are likely to be the source of much consternation for global financial markets.

As such, we anticipate a broad-based pickup in volatility, given the heighted Correlation Risk we’ve seen across all asset classes to date. This tug-of-war on the US dollar is an acute risk that needs to be managed around, particularly from a timing perspective. In short, the playbook is as follows: Republican compromise = dollar DOWN; Democrat compromise = Dollar UP. Gaming Policy is about to get a little more challenging in the coming months.

Historic Impasses

Below we briefly touch upon prior debt limit impasses and how key financial markets fared in the months leading up to and just beyond the eventual increases. Keep in mind that the charts below are not at all an attempt to forecast what might happen in the coming months; like history itself, no two debt ceiling periods are alike. Rather, the illustrations below are merely points of reference for pondering how the markets will react this time around.

1985: In September of 1985, the Treasury Department became unable to issue new securities as a result of the statutory limit on federal debt being reached. As such, it was forced to take “extraordinary measures” consisting of and similar to the maneuvers listed in the section above. The debt limit was temporarily increased on November 14, 1985 and permanently increased on December 12,1985 from $1.82T to $2.08T. In addition, the accompanying legislation granted the Treasury Department authority to declare a “debt issuance suspension period” in future debt limit impasses.

1995-96: On November 15, 1995, the Treasury Department declared the first ever “debt issuance suspension period” and used “extraordinary measures” to finagle its way through the beginning of the next year. It subsequently notified Congress that it did not have enough cash on hand to pay the March 1996 Social Security benefits, at which point Congress responded by temporarily increasing the debt limit in an amount commensurate to the upcoming benefit distribution ($29B). Just one day before the March 15th deadline, Congress acted to extend the temporary increase by two weeks until March 30th. And just one day before that deadline, Congress passed legislation permanently increasing the debt limit to $5.5T from $4.9T.

2002-03: At several instances during this two year period, the Treasury Department had to declare “debt issuance suspension periods” (April 4, 2002-April 16, 2002; May 16, 2002-June 28, 2002; and February 20, 2003-May 27, 2003) and take “extraordinary measures” to smooth the timing of cash flows in order to meet the federal government’s obligations. The debt limit was permanently increased twice during this legislative impasse; first on June 28, 2002 to $6.4T from $5.95T and subsequently on May 27, 2003 to $7.38T.

Summary

While we expect the US dollar to find a bid at some point in the coming months due to the market eventually looking through this impasse to the increased likelihood of meaningful fiscal reform in the intermediate term, we do think the weeks leading up this occurrence will provide another opportunity for the global currency market to vote against the short-term political compromises we continue to see out of Washington D.C. If anything, this exercise will continue to expose to the world just how far away both sides are from agreeing on a credible solution to the #1 issue driving the US’s long-term fiscal and balance sheet deterioration – entitlement spending. Over the near term, we expect the tough choices to continue to get punted to future sessions; as such, we remain short the US dollar and long Gold in the Virtual Portfolio – for now. That will most likely change in the coming months.

Darius Dale

Analyst

Sources: US Department of the Treasury, CBO, Government Accountability Office, The Hill.com, Fox News, Congressional Research Service, and National Association of State Budget Officers.

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